Ifs Iipm,Delhi Shoubhagya

8/14/2019 Ifs Iipm,Delhi Shoubhagya

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SUBMITTED BY:

SHOUBHAGYA RANJAN MAHAKUD

INDIAN INSTITUTE OF PLANNING AND MANAGEMENT, DELHI


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Part 1

1. ABC Ltd. has a floating rate liability and wants a fixed rate exposure. They enter into a

2 year quarterly pay Rs.4Mn fixed for floating interest rate swap as the fixed rate payer.The counterparty to the agreement is XYZ Ltd. The fixed rate is 6% and the floating rateis 90-day Libor +1%, with both calculated based on a 360-day year. Realizations ofLIBOR are:

- Current 5%- In 1st Quarter 5.5%- In 2nd Quarter 5.4%- In 3rd Quarter 5.8%- In 4th Quarter 6.0%

Calculate the payment made and by which party in each quarterANS:


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2. Consider a Rs.2 Mn Forward Rate Agreement (FRA) with a contract rate of 5%.

The contract expires in 30 days from now and is based on a 90-day LIBOR. If the

90-day LIBOR is 6% at settlement, compute the cash settlement at expiration and

identify which party makes the payment.

3. This question has 3 parts(i) If a 182-day Treasury Bill of Rs. 100 face value is issued for a price

of Rs. 93.75. Calculate the Yield on this Treasury Bill?

(ii) If a 30-day Certificate of Deposit of Rs. 3,00,000/- face value isissued for a price of Rs. 2,60,000/-, calculate the Yield on this

Certificate of Deposit?

(iii) If a 60-day Commercial Paper of Rs. 10,00,000/-, face value isissued at an effective Discount of 9%, calculate the Issue Price of

this instrument, given that it is a rear-end discount instrument?


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Part 2

Q.NO.-1: What were the key causes for sub-prime financial crises?

What did it pose a threat to the global financial system?

What were the key causes for sub-prime financial crises?

This began initially with a sharp rise in home foreclosures the United Statesduring the fall of 2006 and became a global financial crisis within a year. It is an overspilling talk in the newspapers and financial bogs referring to the Sub prime crisis in itscommon parlance as the crisis began with the bursting of the housing bubble in the U.S.Thus the origin of the subprime crisis could be traced through the ill regulated realitysector norms of the US. As a result of the same there were high default rates on subprime

and other mortgage loans. The main fault took place essentially because the loans wereextended primarily to higher-risk borrowers with lower income and lesser credit historythan the prime borrowers. The housing prices in America had started to drop moderatelyin 2006-2007 in many parts of the U.S., refinancing became more difficult.

Defaults and foreclosure activity increased dramatically. The mortgage lenderswho had retained the risk of payment default, which is commonly known as Credit Risk,were the first to be affected, as borrowers became unable or unwilling to make payments.Most of the blame for this should be pointed at the mortgage originators (lenders) forcreating these problems. It was the lenders who ultimately lent funds to people with poorcredit and a high risk of default.

Many lenders and buyers in the markets were playing an extremely risky game bybuying houses they could barely afford. They were able to make these purchases withnon-traditional mortgages (such as 2/28 and interest-only mortgages) that offered lowintroductory rates and minimal initial costs such as "no down payment". Their hope lay inprice appreciation, which would have allowed them to refinance at lower rates and takethe equity out of the home for use in other spending. However, instead of continuedappreciation, the housing bubble burst, and prices dropped rapidly.

1. Inability of homeowners to make their mortgage payments;Firstly, one must understand that though sub-prime crisis is being used as a generic

term, it actually refers to a credit problem among sub-prime borrowers (they account for 8%of total mortgages in the US) in the residential market in the US. Like borrowers anywherein the world, the interest paid on residential mortgages in the US is linked to the centralbanks benchmark and in this case, the US Federal Reserves Fed Funds Rates.

Between 2004 and 2006, because of incipient inflation in the US economy, theFederal Reserve or Fed increased its discount rate from 1% all the way to 5.25%. Because ofthis, holders of residential mortgages too saw their payments on their house loans rise. Thisrise in rates was a disaster in the making for the banks that gave loans to sub-primeborrowers.


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Because the first issue with sub-prime borrowers is that they are likely to be low-income people. When faced with higher mortgage payments, they fell behind on theirpayments and in cases, some also became delinquent and banks started repossessing houses.

The lenders take the hit when borrowers default:That is because mortgages held bybanks are typically bundled and sold to other institutions. These institutions will then slicethese mortgages into residential mortgage-backed securities (RMBS) or in other words,securities that are backed by collateral, the collateral here being the mortgages held by sub-prime borrowers.

Internally, it started with the financial institutions lending to consumers with badcredits, offering the gimmick of 0 down with variable interest rates that were due toincrease later on. When the "time" came and people's monthly mortgage payments wereeither doubled or tripled, they struggled with the payments and became delinquent. Aslayoffs slowly creeped up at the beginning of 2006, they could no longer pay their

mortgage, so foreclosures started rising at a rapid rate. This significantly cut into thebanks' profits/liquidity flow and they already slammed on their "brakes" over lastsummer, implementing new lending policies and tightening standards. The banks alreadyknew they were in trouble, so they weren't even willing to lend to each other in theirshort-term 30-day cycles (a type of common short-term loans banks do for each other).Yet they refused to "release the numbers," either because all the numbers of writedownsand writeoffs truly haven't been calculated yet or they simply didn't want the public toknow the truth, afraid it would drive down the stock market. Their initial "released"(publicized) estimation of $15 billion in writedowns have grown to between $300-$500billion globally by now (as of last week's report). Like a snowball effect, as more andmore people got laid off, they had no money to pay their credit cards and everything else

either. So this has cut into people and businesses spendings, driving down the GDP index(national spending report) for the last 2 quarters. A "recession" is defined as 2 or moreconsecutive quarters of low GDP numbers. 2 consecutive quarters have already passed,and more layoffs are in store for upcoming months, so it's doubtful they will be spendingmuch to drive up that GDP. And companies are laying off employees to cut costs, so it'salso doubtful they will spend much either.

Externally, these banks sold these mortgage-backed securities to foreign investors,namely foreign banks and other major investors. When these banks got in trouble,whoever bought the shares of these securities are in trouble, too. So this crisis is stillspreading. The total numbers of losses and layoffs haven't come in yet.

When there's no money circulating the market, there's no magic the Fed Reservecan do to make money appear. They can't just "print" more money and start droppingcash from helicopters. And every time the Fed Reserve cuts interest rate, it drives downthe value of the U.S. Dollar, which is one of reasons for such a sharp rise in oil prices andother consumer goods. So now we have this deflationary economic state of a recession,but the weakening dollar drives up the cost of imports and decreasing the profit of ourexports.


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4. Poor Government regulations:In response to a concern that lending environmentwas too easy or say, not properly regulated, the House and Senate are both consideringmaking some new bills to regulate lending practices.

What did it pose a threat to the global financial system?

In mid-2007, mounting losses in subprime mortgage markets triggered disturbancesthroughout the international financial system. The scale of the turmoil has beensurprising, given the small size of the U.S. subprime market in relation to global financialmarkets. Not only is subprime a comparatively small market, its problems were knownwell in advance: when the rapid rise in housing prices stopped in 2006, it was inevitablethat many subprime borrowers would have difficulty making payments, particularly thosewhose adjustable mortgage rates were scheduled to reset in 2007 and 2008.Thecombination of impacts due to credit risk and liquidity risk caused several majorcorporations and hedge funds to shut down or file for bankruptcy. Stock market declinesamong both depository and non-depository financial corporations were dramatic. Manyhedge funds and other institutional investors holding MBS also incurred significantlosses.

The subprime crisis has resulted into something that places downward pressure oneconomic growth, because significant losses from subprime loans have reduced the


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willingness of banks to loan funds to other financial institutions and to consumers. Suchloans increase investment by businesses and consumer spending, which drive theeconomy. A separate but related dynamic is the downturn in the housing market, where asurplus inventory of homes has resulted in a significant decline in new home construction

and housing prices in many areas.

Drastic fluctuation in stock market--investors began to worry about whetherthe Subprime crisis will turn into a global economic one.

Many investment banks, mortgage lenders, real estate investment trusts andhedge funds suffered significant losses as a result of mortgage paymentdefaults or mortgage asset devaluation.

--New Century Finance; American Home Mortgage

--Merrill Lynch;Citigroup

As closely connected with the United States financial markets, the euro zonesand Japan are experiencing a rough time as well.

Nevertheless, a wide range of financial institutions have been affectedadversely, many of which had no direct exposure to the subprime mortgagemarket. Almost weekly since July 2007, the financial press has highlighted anew trouble spot, such as hedge funds, small European banks, issuers ofcommercial paper, conduits for securitization of loans, credit swaps, jumbomortgages, money market funds, consumer lenders, bond insurers, state andlocal government investment funds, and so on. The links between many of

these markets and subprime mortgages are tenuous, but they are widelyviewed as symptoms of a common underlying problem. As closely connectedwith the United States financial markets, the euro zones and Japan areexperiencing a rough time as well.

The stock market has certainly perceived systemic weakness across financialsectors. As Figure 1 below indicates, share prices for large banks, smallbanks, and investment banks have all significantly underperformed the marketas a whole, as represented by the Standard & Poors 500 index. Between July2007 and March 2008, shares in those companies lost about a third of theirvalue.


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SOURCE: GLOBAL FINANCIAL DATA

Financial market conditions have not stabilized, despite the efforts ofregulators. The ultimate fear of the Federal Reserve is that the flow ofcredit to sound business and consumer borrowers will be disrupted,causing spending and investment to contract sharply throughout theeconomy. To date, there has been tightness incertain lending markets,

but credit remains generally available. This report focuses on the tools thatregulators primarily but not exclusively the Federal Reserve haveemployed or devised to avert a full-blown financial crisis that would beexpected to worsen macroeconomic conditions.

Main impact to China--export markets shrinks--import-rely country--shrinking profits of many Chinese manufactures and foreign tradeEnterprises


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1. What are the causes for increase in Oil prices in the last 6 months? Supportyour answer with credible data and analysis. Does the rapid increase in oil prices

pose a threat to the Indian Financial System? Why or why not?

Over the past six months, oil prices have steadily risen. Stronger demand fromChina and India has finally caught up with years of limited investment in drilling andnew exploration. However, unlike past oil price hikes, this one has had only a modestimpact on either real economic activity or inflation. The reason for this is simple: As ashare of the economy, energy is less important today than at any time in the past 40 years.Rising energy productivity has limited the ability of rising oil prices to rock the economy.

What the recent rise in oil prices has done is to set off another round ofinvestment in energy production, while dampening demand. This market response tohigher oil prices will act to bring prices down in 2007.

The demand for oil is refered to as being "inelastic." This means that a relativelysmall change in demand or supply will result in a relatively large chage in price.Goods that are essential, like food and fuel, do not have readily availablesubstitutes, so it takes a very large change in price to effect the amount demandedto bring supply and demand into equilibrium. So for instance, a 5% increase in thedemand for oil might result in a 10% increase in the price. So all the effectsmentioned above have a large impact.

The high price of crude oil is due to unregulated future speculation which isdetermining the price of physical barrel.

Speculation: Hedge funds and investment banks were forced to make huge write-downs with the collapse of the real estate market in the US due to the problems inthe sub-prime sector. In order to shore up such losses many speculators moved

into the last remaining commodities that could be betted upon - food and oil. AJune 2006 US Senate Permanent Subcommittee on Investigations report on "TheRole of Market Speculation in rising oil and gas prices" noted, "... there issubstantial evidence supporting the conclusion that the large amount of

speculation in the current market has significantly increased prices"

Although Oil production has continued to increase and although consumption isset to rise.

The result of a big trade deficit is that foreign countries hold a large amount of USdollar. When US has not enough goods or assets to exchange these dollars back, ithas to think of a way to make these countries to keep the dollar instead ofdumping it. One way is to push up the oil price. A country which consumes one

million barrel of oil a year has to keep 30 million dollars in bank (when oil priceis at 30 dollars/ barrel) Then how much should it reserve if the oil price jumpedfrom 30/barrel to 60/barrel? It has to double its dollar reserve to 60 millions. Solarge amount of dollars were locked up in bank as oil payment (Dollar is theappointed currency in oil trading.)

Western consumption and reliance on oil has played a direct role in oil price risesand will continue to have a strong influence on future oil prices. As Westerneconomies are built upon consumption the need for oil based products such asfuel for cars, fuel for air conditioners and fridges, lubricants, plastics and food


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preparation will continue to rise and affect oil prices unless alternative fuels arediscovered.

Economically the US dollar has partially caused the current price hike as globaloil is priced in dollars. Nations around the world would need to give up their owncurrency in order to purchase dollars which can then be used to buy Oil. Thismakes the exchange rate between such a country and the dollar a critical issue as aslight change in the exchange rate will mean a nation may even need to borrowmoney to purchase an essential commodity such as oil. The current surge in Oilprices lay primarily in speculators moving out of the US housing market and intocommodities and with the US printing more and more dollars to inflate its wayout of the sub-prime crisis. With oil being priced in dollars, they will continue tofluctuate as more and more dollars work their way onto the markets.

The purchasing power of the dollar can be seen when compared to gold, gold hasremained extremely stable over the past century, indeed, over most of history. The

price of 100 barrels of oil measured in ounces of gold has remained fairly stablebetween 5 and 10 ounces of gold for the last 100 years. From just 1973 to 2008,the price of a barrel of oil in US Dollars increased by 3300%. Over the sameperiod the number of ounces of gold required to buy 100 barrels of oil only roseby only 18%. It is not necessarily oil prices that fluctuate but the value of the USdollar, in which oil prices are quoted, that fluctuates. This is why some nations arecalling for oil to be priced in Euros'


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Yes, the rapid increase oil prices pose a threat to the Indian Financial System:

Double digit inflation with oil price hike. Corporate tax outflows and fund outflows from the equity market are likely to

lead to a liquidity squeeze, pushing overnight borrowing rates higher.

Bond market falls as the oil prices hikes. The member states of the Gulf Cooperation Council will earn $5 trillion to $9

trillion from exports of crude oil. Depending on oil prices and levels ofdomestic investment, 30 to 60 percent of this windfall could flow intooverseas capital markets.

Even under conservative scenarios, the assets of the new power brokerspetrodollars, Asian central banks, hedge funds, and private equitywillnearly double to $15.2 trillion in 2012.

Depending on oil prices and levels of domestic investment, 30 to 60 percent ofthis windfall could flow into overseas capital markets.

inflation and food prices peaks out and if oils stabilizes or even comes down abit, there is much more inflation in the pipeline and what it is going to take toget rid of that is tighter economic policy, tighter monetary policy and withexchange rates not appreciating so much in the recent weeks that meanshigher interest rates and markets.

Rising price of crude oil and spiralling inflation weighed heavily on the Indianequities market.

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Ifs Iipm,Delhi Shoubhagya